PRODUCTION

OUTLINE

6.1 The Technology of Production

6.2 Production with One Variable Input (Labor)
6.3 Production with Two Variable Inputs
6.4 Returns to Scale

Production
The theory of the firm describes how a firm makes costminimizing production decisions and how the firms
resulting cost varies with its output.

The Production Decisions of a Firm

The production decisions of firms are analogous to the
purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices

Production
The process of transformation of resources (like land,
labour, capital and entrepreneurship) into goods and
services of utility to consumers and/or producers.
The process of creation of value or wealth through the
production of goods and services that have economic value.
process of adding value may occur
by change in form (input to output, say steel into car), or
by change in place (supply chain, say from factory to
dealers/retailer), or
by changing hands (exchange, say from retailer to consumer).

Goods includes all tangible items such as furniture, house,

machine, food, car, television etc
Services include all intangible items, like banking,
education, management, consultancy, transportation.

Types of Inputs
Technology
determines the type, quantity and proportion of inputs.
also determines the maximum limit of total output from a
given combination of inputs.
at any point of time, technology will be given; impact of
technology can be seen only over a period of time.
Fixed and Variable Inputs
Production analysis of a firm uses two distinct time frames:
the short run: refers to a period of time when the firm cannot
vary some of its inputs.
the long run., refers to a time period sufficient to vary all of its
inputs, including technology.

Variable input : that can be made to vary in the short run,

e.g. raw material, unskilled/semi skilled labour, etc.
Fixed input: that cannot be varied in the short run, e.g.
land, machine, technology, skill set, etc.

Factors of Production
5 factors of production
Land

Anything which is gift of nature and not the result of human effort, e.g.
soil, water, forests, minerals
Reward is called as rent

Labour

Physical or mental effort of human beings that undertakes the

production process. Skilled as well as unskilled.
Reward is called as wages

Capital

Wealth which is used for

equipment/intermediary good
It is outcome of human efforts
Reward is called as interest

further

production

as

machine/

Enterprise

The ability and action to take risk of collecting, coordinating, and

utilizing all the factors of production for the purpose of uncertain
economic gains
Reward is called as profit

Organization

Combination of highly skilled labour

capital/managerial aspect of business.
Reward is called as salary

and

specialized

human

Production Function
A technological relationship between physical inputs and
physical outputs over a given period of time.
shows the maximum quantity of the commodity that can be
produced per unit of time for each set of alternative inputs,
and with a given level of production technology.
Hence it can be said that production function is:
Always related to a given time period
Always related to a certain level of technology
Depends upon relation between inputs.
Normally a production function is written as:

Q = f (L,K,I,R,E)
where Q is the maximum quantity of output of a good being
produced, and L=labour; K=capital; l=land; R=raw material;
E= efficiency parameter.
Technical efficiency is defined as a situation when using
more of one input with either the same amount or more of
the other input must increase output.

Production Function with One Variable

Input
Also termed as variable proportion production
function
It is the short term production function
Shows the maximum output a firm can produce
when only
Q fone
( L, Kof
) its inputs can be varied, other
inputs remaining fixed:

TP f ( K ,L)

where Q = output, L = labour and K = fixed amount

of capital

Total product is a function of labour:

Average Product (AP) is total product per unit of

TP
variable input
APL
L
Average product of labour (APL) is:
Marginal Product (MP) is the addition in total
output
TP
per unit change in variable input MPL
Marginal product of labour (MPL) is:
L

THE TECHNOLOGY OF PRODUCTION

The Short Run versus the Long Run

short run Period of time in which quantities of one or

more production factors cannot be changed.
fixed input

Production factor that cannot be varied.

long run Amount of time needed to make all

production inputs variable.

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

TABLE 6.1 Production with One Variable Input

Amount
of Labor (L)
0

Average
Product (q/L)

Marginal
Product (q/L)

Amount
of Capital (K)
10

Total
Output (q)
0

10

10

10

10

10

30

15

20

10

60

20

30

10

80

20

20

10

95

19

15

10

108

18

13

10

112

16

10

112

14

10

108

12

10

10

100

10

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The Slopes of the Product Curve

Figure 6.1
Production with One Variable Input

The total product curve in (a) shows

the output produced for different
amounts of labor input.
The average and marginal products
in (b) can be obtained (using the
data in Table 6.1) from the total
product curve.
At point A in (a), the marginal
product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average
product of labor is 20, which is the
slope of the line from the origin to B.
The average product of labor at
point C in (a) is given by the slope
of the line 0C.

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The Slopes of the Product Curve

Figure 6.1
Production with One Variable Input
(continued)

To the left of point E in (b), the

marginal product is above the
average product and the average is
increasing; to the right of E, the
marginal product is below the
average product and the average is
decreasing.
As a result, E represents the point
at which the average and marginal
products are equal, when the
average product reaches its
maximum.
At D, when total output is
maximized, the slope of the tangent
to the total product curve is 0, as is
the marginal product.

Law of Variable Proportions

Total
Outpu
t

C
TPL

B
A

O
Total
Output

Labour

Stage I

A*

Stage II

Stage
III

B*

C*
MPL

APL
Labour

First stage
Stage I would begin from the origin and
continue to the point where AP attains
maximum value . Hence ,Increasing Returns
to the Variable Factor
MP>0 and MP>AP
Second stage
The total output increases but less than
proportionate to the increase in labour. In
this stage MP falls and the stage is known as
Diminishing Returns to a Variable Factor.
Both AP and MP are positive but declining.
MP>0 and MP<AP
Third Stage
Negative Returns
MP<0, TP is falling and AP is falling but
positive
Technically inefficient stage of production
A rational firm will never operate in this
stage

Explanation to the diagram of law of variable

proportions

Panel A: explains the

behaviour of TP
There points A B C on the TP
curve
Of them, A is the point of
inflexion of the TP curve.
Note : that point A* on MP
curve corresponds to A point
on the MP curve in panel B.
Point B on the TP curve is
where the AP =MP
Point C in panel A =where TP
is maximum;beyond C TP
starts falling.

Panel B Expalins the behaviour of

AP n MP curves with successive
changes in the variable input
labour
A* is the point where MP attains
the highest and starts falling
thereafter.
You can follow from panel B that
AP increases till it reaches
B*where it is maximum.AP starts
falling to the right of B*
Notice the counterpart C* of C in
panel B;it is the point where the
MP curve cuts the quantity axis
and dips down. As if obvious
,beyond C* the value of MP is
negative.

6.2

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The Law of Diminishing Marginal Returns

law of diminishing marginal returns

Principle that as the use

of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

Figure 6.2
The Effect of Technological
Improvement

Labor productivity (output

per unit of labor) can
increase if there are
improvements in technology,
even though any given
production process exhibits
diminishing returns to labor.
As we move from point A on
curve O1 to B on curve O2 to
C on curve O3 over time,
labor productivity increases.

The law of diminishing returns

As the additional units of a variable input are combined

with a fixed input ,at some point the additional output(i.e.
the marginal product) starts to diminish
Suppose you were a manager, you could track the MP of
your employees.
Variable input
(employees)

TP

MP

AP

18

10

29

11

9.67

39

10

9.75

47

9.4

52

8.67

56

8h

52

-4

6.5

2 Key concerns in Practical Nature

1.There is nothing in the law that states that when diminishing
returns will occur.
Law merely says that if additional units of a variable input ..are
combined with a fixed input at some point, the MP will start to
diminish.
Therefore, a manger can only discover diminishing returns by
experience, trial and error.
Hindsight is more valuable than foresight
2.When economists first stated this law they made very restrictive
assumptions about the nature of the variable inputs being used.
They assumed all inputs added to the production process were
exactly the same in individual productivity.
Reason for a particular unit of an inputs MP would be higher or
lower than the others used is because of the order in which it is
added to the production process

Multiple Inputs
In a multiple input case we must
consider the relationship between
the ratio of the marginal produce of
one input and its costs to the ratio of
the marginal product of the other
input (inputs) and its (their) cost.
Mathematically ,for K inputs
MP1/W1 = MP2/W2 = MPk/ Wk

Caselet
Suppose you are the production manager of a
company that makes computer parts and
peripherals in Malaysia and China. At current
level of production and input utilization in two
countries you find that
MP in malaysia= 18
MP in China= 6
Wage rate in M=$6 /hr
Wage rate in C= $3/hr
How much would u produce in each
manufacturing facility?

Labour is cheap in China so a firm might be tempted to produce more

in China.
However, a closer look at the MP : Wage ratios reveals opposite
conclusion
18/$6 >6 /$3
This means at the margin, the last dollar spent on a unit of labour in
China would yield 2 units of output while in Malaysia this would result
in 3 additional units of output.
This implies that a firm should begin to shift its production from China
to Malaysia, until the two ratios are equalized.
In theory, this equilibrium point would occur because as more of
labor is used in Malaysia, Law of DR would start reducing the MP of
labor in this country. With less labor being used in China, Law of DR
would work in reverse, causing the MP of labour in this country to rise.
This assumes a short run condition whereby complementary fixed
inputs are used along with labour remaining constant.
This is the basic model. Now other factors can also be brought in. If
these factors outweigh the MP-input cost criteria, a company may
modify its decision.
Political and economic risk factors (Malaysian Government imposed
foreign exchange controls in 1998) China is a fairly stable economy,
leader dont impose any such trade and finance restrictions. Proximity

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Isoquants

TABLE 6.4 Production with Two Variable Inputs

LABOR INPUT
Capital Input

20

40

55

65

75

40

60

75

85

90

55

75

90

100

105

65

85

100

110

115

75

90

105

115

120

isoquant

Curve showing
all possible combinations of
inputs that yield the same
output.

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Isoquants
isoquant map

Graph combining a number of

isoquants, used to describe a production function.

Figure 6.4
Production with Two Variable Inputs

A set of isoquants, or isoquant

map, describes the firms
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year
at points such as B) and
to isoquant q3 (90 units per year
at points such as C and E).

Characteristics of Isoquants

Downward sloping
Convex to the origin
A higher isoquant represents a higher output
Two isoquants do not intersect
Capita
l

Capital

C
B

Q2
Q0

Q1

Labour

Q1
Q2
Labour

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Diminishing Marginal Returns

Holding the amount of capital

fixed at a particular levelsay
3, we can see that each
additional unit of labor
generates less and less
additional output.

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Substitution Among Inputs

marginal rate of technical substitution (MRTS) Amount by
which the quantity of one input can be reduced when one extra
unit of another input is used, so that output remains constant.

Figure 6.5
Marginal Rate of Technical
Substitution

Like indifference curves,

isoquants are downward sloping
and convex. The slope of the
isoquant at any point measures
the marginal rate of technical
substitutionthe ability of the
firm to replace capital with labor
while maintaining the same level
of output.
On isoquant q2, the MRTS falls
from 2 to 1 to 2/3 to 1/3.

(MP ) / (MP ) (K / L) MRTS (6.2)

L
K

MRTS = Change in capital input/change in labor input

= K/L (for a fixed level of q)

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Production FunctionsTwo Special Cases

Figure 6.6
Isoquants When Inputs Are
Perfect Substitutes

When the isoquants are

straight lines, the MRTS is
constant. Thus the rate at
which capital and labor can
be substituted for each
other is the same no matter
what level of inputs is being
used.
Points A, B, and C
represent three different
capital-labor combinations
that generate the same
output q3.

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Production FunctionsTwo Special Cases

fixed-proportions production function Production function
with L-shaped isoquants, so that only one combination of labor
and capital can be used to produce each level of output.
The fixed-proportions production function describes
situations in which methods of production are limited.
Figure 6.7
Fixed-Proportions
Production Function

When the isoquants are Lshaped, only one

combination of labor and
capital can be used to
produce a given output (as at
point A on isoquant q1, point
B on isoquant q2, and point C
on isoquant q3). Adding more
labor alone does not
increase output, nor does
adding more capital alone.

6.3

PRODUCTION WITH TWO VARIABLE INPUTS

Figure 6.8
Isoquant Describing the
Production of Wheat

A wheat output of 13,800

bushels per year can be
produced with different
combinations of labor and
capital.
The more capital-intensive
production process is
shown as point A,
the more labor- intensive
process as point B.
The marginal rate of
technical substitution
between A and B is
10/260 = 0.04.

6.4

RETURNS TO SCALE

returns to scale

Rate at which output increases as

inputs are increased proportionately.

increasing returns to scale

Situation in which output

more than doubles when all inputs are doubled.

constant returns to scale

Situation in which output

doubles when all inputs are doubled.

decreasing returns to scale

Situation in which output

less than doubles when all inputs are doubled.

6.4

RETURNS TO SCALE
Describing Returns to Scale
Figure 6.9
Returns to Scale

When a firms production process exhibits

constant returns to scale as shown by a
movement along line 0A in part (a), the
isoquants are equally spaced as output
increases proportionally.

However, when there are increasing

returns to scale as shown in (b), the
isoquants move closer together as
inputs are increased along the line.

Returns to Scale
Returns to Scale show the degree by which the level of output
changes in response to a given change in all the inputs in a
production system.
Panel b

Panel a

Capita
l

C
B
A

Capita
l

C2
B2

200
Q
100Q
50Q

Labour

A2

Panel c

Capita
l
400Q
A

150Q
50Q

Labour

C1

50Q

125Q
90Q

Labour

Constant Returns to Scale : When a proportional increase in

all inputs yields an equal proportional increase in output (Panel a)

Increasing Returns to Scale : When a proportional increase

in all inputs yields a more than proportional increase in output
(Panel b).

Decreasing Returns to Scale : When a proportional increase

in all inputs yields a less than proportional increase in output (Panel

c).

Causes of returns to scale

IRTS:
indivisibilty of the factors,
Specialisation of labour and
machinery,
integration of process.

Isocost Lines
Total Cost is sum of Labour cost (wL) and Capital cost (rK) where
wage (w) and interest (r)

C wL rK
The isocost line represents
the locus of points of all the
different combinations of two
inputs that a firm can procure,
given the total cost
and
prices of the inputs.

Capita
l
A

A
A1
O

B1 B B2

Labou
r

The (absolute) slope of this line is

equal to the ratio of the input prices.

C
K
w
Slope
r
L C
r
w

Producers Equilibrium
Capital
A
C

K*

D
O

L*

Q
Q2 3

Q1

Q0
B

Labou
r

AB is the isocost line

Any point below AB is feasible but not
desirable
E is the point of tangency of Q2 with
isocost line AB
Corresponds to the highest level of
output with given cost function.
Firm would employ L* and K* units of
labour and capital
Q3 is beyond reach of the firm

Points C and D are also on the same

Maximization of output subject to
isocost line, but they are on isoquant Q1,
cost constraint
which is lower to Q2. Hence show lower
output.
Necessary condition for equilibrium
E is preferred to C and D, which is on
Slope of isoquant = Slope of
isocost line
the highest feasible isoquant.

Producers Equilibrium
Capital

A2
A

A1
K

E
S

O
L

B1 B

B2

Labour

Minimization of cost for a given

level of output
Necessary condition for equilibrium
Slope of isoquant = Slope of
isocost line

Firm has decided the level output to be

produced shown by the isoquant Q
Will be indifferent between output
combinations shown by R, S, E on
isquant Q.
Has to ascertain that combination of
inputs Labour and Capital which
minimizes the cost of production
Hence a map of isocost lines will be
prepared
The isocost lines are parallel to each
other because price of the inputs is
given.
A1B1 line is not feasible
It will use OK and OL of capital and
labour respectively, at point E which is
also on AB, the lowest possible isocost
line.
R, S are not desirable because they are
on higher cost line A2 B2.

Expansion Path
Capita
l

Expansion
Path

E1

E2

Labour

Line formed by joining the tangency points between various

isocost lines and the corresponding highest attainable isoquants
is known as Expansion Path.
For homogeneous production function and given factor prices
(and hence factor ratio):
expansion path is a straight line through the origin.
For non- homogeneous production function:
optimal expansion path is non linear.

Returns to Scale
Returns to Scale show the degree by which the level of output changes in
response to a given change in all the inputs in a production system.
Panel b

Panel a
Capita
l

C
B
A

Capita
l

C2
B2

200
Q
100Q
50Q

Labour

A2

Panel c
Capita
l
400Q
A

150Q
50Q

Labour

C1

50Q

125Q
90Q

Labour

Constant Returns to Scale : When a proportional increase in

all inputs yields an equal proportional increase in output (Panel a)

Increasing Returns to Scale : When a proportional increase

in all inputs yields a more than proportional increase in output
(Panel b).

Decreasing Returns to Scale : When a proportional increase

in all inputs yields a less than proportional increase in output (Panel

c).

Cobb-Douglas Production Function

Proposed by Wicksell and tested against statistical evidence
by Charles W. Cobb and Paul H. Douglas in 1928
L
Q AK where
, are constants. A is the technological
parameter, is the elasticity of output with respect to
capital, and is the elasticity of output with respect to
labour.
Properties
Homogeneous of degree (+)
The returns to scale is immediately revealed by the sum of
the two parameters and
Constant Returns to Scale: ( +) = 1
Increasing Returns to Scale:
( + ) > 1
Decreasing Returns to Scale:
( + ) < 1

Isoquants are negatively sloped and convex to the origin

MRTSLK is a function of input ratio
Elasticity of substitution is equal to 1